Principles of economics
Central banking and Monetary
policy
Tomislav Herceg, PhD
Central Bank
• The most important macroeconomic policy maker
• Banks of all the banks, monopolist in the money
issue
• Croatian National Bank (Hrvatska narodna banka)
was founded in 1990.
Other central banks:
• EU: ECB (European Central Bank)
– www.ecb.europa.eu
• USA: FED (Federal Reserve District)
– www.federalreserve.gov
Central bank properties
• One of 4 pillars of the state, autonomous towards
central government
• Council of governors set by the parliament, not
by the government
• Its activities form national monetary policy
• Governed by the Council (for HNB):
1. Executive board – governor and 4 vice
governors.
2. External members – 8 councilors
Monetary policy
• Macroeconomic policy created by the central
bank using supply of money management
• 3 forms:
– Expansive (M grows faster than GDP)
– Restrictive (M grows slower than GDP)
– Neutral (M grows at the same pace as GDP)
Policy objectives of the CB
• Economic growth (gy) in line with the
economy’s potential to expand
• High employment (low u)
• Low inflation (Π)
• Moderate interest rates (i)
CB operations
• Open-market operations: buying and selling
government securities (bonds and bills)
• Discount-rate policy (setting discount rate at
which banks can borrow money)
• Reserve requirement policy (setting legal
requirement on deposits in banks)
• Forex operations (buying and selling foreign
exchange)
=> These operations alter supply of money M, in
other words, these are tools of monetary policy
Open market operations
• By buying and selling government bonds and
bills supply of money changes: when CB sells
bonds, M falls, when CB buys bonds, M rises.
• Open market operations are conducted in the
REPO auctions.
• The most used monetary instrument
Discount-Rate policy
• CB announces discount rate at which
commercial banks can borrow money from CB.
• Rarely used in Croatia, banks rather borrow
one from another due to tight controls of
banks that use CB loans.
• Currently at 7%
Reserve requirements
• By changing reserve rate r monetary multiplier
changes: m = 1/r.
• Monetary aggregates in Croatia:
• M1: cash and deposits on current accounts
• M1a: M1 + state deposits
• M4: all liquid assets
(Mill. HRK)
Reserve money
Money M1
Money M1a
Broadest money M4
Sept. 2014
62.746,1
63.824,1
65.231,6
282.533,6
Open economy monetary policy
• Domestic currency is affected by foreign holding of
domestic currency. If too much money enters economy
central bank has sterilize it by contracting supply of
money M.
• Exchange rate mechanism is crucial in that process:
• Fixed exchange rate: country pegs against other
currency at fixed exchange rate and has to adjust its
economy so as to keep that rate.
• Floating exchange rate: exchange rate freely changes
• Operated floated exchange rate (snake in the tunnel):
exchange rate floats between certain endpoints
HRK/€
• Croatian kuna pegs against Euro in an
operated floating exchange regime (mostly
between 7.2 HRK and 7.6 HRK per EUR):
7.800000
7.600000
7.400000
7.200000
7.000000
6.800000
6.600000
6.400000
6.200000
1994. 1995. 1996. 1997. 1998. 1999. 2000. 2001. 2002. 2003. 2004. 2005. 2006. 2007. 2008. 2009. 2010. 2011. 2012. 2013.
Monetary transmission mechanism
• MTM is the route by which changes of money supply M
affect output Y, employment E, prices P and inflation Π.
• MTM with restrictive monetary policy:
1. Sale of government securities (or increase in the
reserve requirement, or sale of foreign currency)
2. Money supply is reduced
3. Interest rates go up
4. Investment falls
5. Reduction of aggregate demand, output and
employment and inflation
𝒓 ↑→ 𝑴 ↓→ 𝒊 ↑→ 𝑰, 𝑪, 𝑰𝑴 ↓→ 𝑨𝑫 ↓, 𝒀 ↓, 𝝅 ↓, 𝒖 ↑
Money market
• Demand for money is deducted from (a) need to
conduct transaction and (b) desire to save
• Supply of money is created by CB operations in
the commercial bank system
• The intercept of L and M determine interest rate
i
M = supply of money
L = demand for money
0
M
Money market shifts
• Restrictive monetary policy effect
i
M’
M
-money supply contracts
-i rises, M falls
L
0
M
0
M
• Input price rise which causes inflation:
i
M
L’
-L rises
L
-i rises
Monetary transmission mechanism graph (expansive monetary policy)
𝒓 ↓→ 𝑴 ↑→ 𝒊 ↓→ 𝑰, 𝑪, 𝑰𝑴 ↑→ 𝑨𝑫 ↑, 𝒀 ↑, 𝝅 ↑, 𝒖 ↓
i
M
i
M’
Id = investment demand When Y approaches
potential output
monetary expansion
leads only to inflation
L
I(i)
M
0
TE
AD’
I
0
Potential
output
P
I
AD’
AD
AS
AD
45°
45°
0
Y
0
I
0
Y
Effects of monetary expansion in the
long run
• Milton Friedman and his monetaristic school of
economic thought believe that in the long run
monetary expansion leads only to higher level of
prices and output goes back to its previous level
• Why? Because AS tends to be vertical in the long run
and because inflation caused by ME causes a shift of
money demand L causing i to rise, thus reducing I
and AD and everything goes back. i
L’
M
L
0
M
Phillips curve
• Phillips curve shows relation between inflation and unimployment.
• In the short run lower unimployment can be „bought” by higher
inflation (negatively sloped short run Phillips curve).
• Higher inflation leads to rise in interest rates which causes I and
thus AD to fall which lifts Phillips curve upwards
=>In the long run Phillips curve is equal to the NAIRU – Non
Accelerated Inflation Rate of Unemployment
π
NAIRU = long run Phillips curve
short run Phillips curves
0
u
Okun’s law
• Okun’s law is empirical rule observed in the
USA. It says that 1% increase in the
unemployment above its natural level (NAIRU)
causes a gap between current and potential
GDP to increase by 2%.
• Natural rate of unemployment is the rate of
unemployment at potential level of output.
• Cyclical unemployment is the difference
between current and natural u.
Okun’s law in USA and EU
change in unemployment
2
USA: 𝑢𝑡 − 𝑢𝑡−1 = −0,4 𝑔𝑦𝑡 − 3%
1
2
3
GDP growth
2
EU: 𝑢𝑡 − 𝑢𝑡−1 = −1.92(𝑔𝑦𝑡 − 1.75%)
4
Exercise 1
• Liabilities of Croatian National Bank were:
IX/2005
Cash
589 Bill.
Current account deposits1413 Bill.
M1
Share of cash in M1
Find M1 and and share of cash in M1
XI/2007
3194 Bill.
5090 Bill.
solution
• M1 = cash + current account deposits
• Share of cash in M1: Cash/M1
IX/2005
Cash
589 Bill.
Current account deposits1413 Bill.
M1
2002 Bill.
Share of cash in M1
29,42%
XI/2007
3194 Bill.
5090 Bill.
8284 Bill.
38,56%
Exercise 2:
• CNB buys 50 Mill. HRK of national bonds. M1 was
4000 Mill. HRK, cash 1400 Mill. HRK, and required
reserves (OR) were 800 Mill. HRK. Calculate:
• a) current account deposits
• b) required reserve rate
• c) money supply mupltiplier
• d) new deposits
• e) M1 after multiplication proces
Solution
• M1 = 4000, Cash = 1400, OR = 800
• a) Current account deposits:
D = M1 – Cash = 4000 – 1400 = 2600 Bill. HRK
• b) Required reserve rate
r = OR/D * 100 = 800/2600 * 100 = 30,77%
• c) Money supply multiplier
• m = 1/r = = 1/0,3077 = 3,25
• d) new deposits
ND = m * deposit increase
deposits increase = 50 Mill. HRK
ND = 3,25×50 = 162,5 Mill. HRK
• e) New M1
M1’ = M1 + ND= 4000 + 162,5 = 4162,5 Mill. HRK